Money, Financial Institutions, and Inflation

MONEY, FINANCIAL INSTITUTIONS, AND INFLATION MONEY – is a set of assets (things of value) that people use in trading goods and services with other people. Barter involves exchanging goods and services for goods and services. There is a double coincidence of wants (you both want what the other person has). A money economy involves exchanging goods and services for money, that can be exchanged for goods and services. Money increases specialization and efficiency. It lowers transaction costs facilitating trade. Both effects increase welfare and output. FUNCTIONS OF MONEY: (This makes it different from other assets) 1. medium of exchange – used in trading goods and services 2. store of value – a way to hold purchasing power over time (imperfect with inflation) 3. unit of account – measure prices and debt in monetary terms. Money needs to be liquid, divisible, and portable. Fiat monetary system, nothing backing it up (e.g. like gold). It has value because it has purchasing power. DEFINITIONS OF THE MONEY SUPPLY: (held by the nonbanking public) M1 = currency (bills & coins) + travelers checks + checking accounts (demand deposits) = $1364.7 bil as of 1/08, currency = $755.7 bil. About 70% is held outside the U.S. ($2000/person). M2 = M1 + saving deposits + small time deposits (< $100,00) + retail money market mutual funds (excludes IRAs and other retirement accounts)= $7498.7 billion M3 = M2 + large time accounts (>$100,000) + institutional money market mutual funds Monetary Base = currency + reserves in banking system (vault cash + deposits at the Fed)=$822,366 million (2/08) Credit cards are a method of deferred payment, not money. Debit cards are like checks. Annual growth rates: M1 M2 M3 3/03 – 6/03 11.3% 10.6% 7.8% 12/02 – 6/03 10.2% 8.8% 5.7% 6/02 – 6/03 7.0% 8.2% 7.1% The U.S. central bank is the Federal Reserve System (in Japan it’s the Bank of Japan). The “Fed” was established in 1913 and began operation in 1914. FUNCTIONS OF THE FED 1. control the money supply (monetary policy) 2. regulate the banking system 3. lender of last resort 12 regional banks plus the Board of Governors in Washington DC (7 members with 14 year terms, Alan Greenspan is Chairman (4 year term). Regional banks help give entire country (not just New York) a say in policy. FEDERAL OPEN MARKET COMMITTEE or FOMC This is a very important group that makes decisions on the money supply or monetary policy. They meet every 6 weeks. The 12 members the 7 board members + NY Fed president + 4 regional presidents (rotate). FRACTIONAL RESERVE BANKING SYSTEM Actions by the Fed and regular banks influence the money supply. Monetary base = currency held by public + bank reserves Bank reserves = vault cash or deposits at the Fed = $ 73.6 bil. (5/03) Banks accept deposits and make loans for a profit. Reserve Requirement Deposit Range 0% 0 - $9.3 mil. 3% > $9.3 – $43.9 mil. 10% > $43.9 mil. The deposit ranges change (a little each year). BANKS – assets > liabilities => net worth or bank capital > 0 or bank is solvent. When net worth approaches zero or becomes negative, bank fails or goes out of business. As of 6/03 bank assets equal $7,332.1 bil. and liabilities equal $6,818.1 bil, resulting in a net worth of $514 for the entire system. ASSETS LIABILITIES reserves ($73.6 bil.) deposits ($4,706.6 bil.) loans ($4,329.6 bil.) borrowings ($1,474.4 bil) gov’t bonds ($1,142.6 bil.) other (($737.6 bil) other $1,786.3 bil. Money Supply Process Multiple expansion of deposits and the money supply. Required Reserve Ratio = RRR = reserves / deposits = .10 (in this example) A. NO BANKS M = currency = $ 100 B. BANKS WITH 100% RESERVES (You deposit your $100 in the bank for safety) M = currency + deposits = 0 + 100 = $100 (M is the same, only the composition has changed) BANK A Assets liabilities reserves $100 deposits $100 Reserves are cash in the vault C. FRACTIONAL RESERVE BANKING SYSTEM On any given day, law of large numbers, withdrawals are offset by deposits. You don’t need to keep 100% reserves. Keep a fraction as reserves, lend the rest out. Assume RRR = .10 I’m only showing the change in assets and liabilities. Now suppose Bank A decides to make a loan for $90 (holding $10 as reserves). The bank writes a check to the borrower. When the check gets deposited at a bank, the money supply increases. The borrower deposit the funds in Bank B (it could be re-deposited into Bank A again, but I want you to think in terms of the banking system). BANK A BANK B Assets Liabilities Assets Liabilities res 10 dep 100 res 90 dep 90 loans 90 Bank A is loaned out. It has no excess reserves (reserves beyond the 10% requirement). Check clearing works like this. Assume that both banks hold reserves at the Fed. Once the check is deposited into Bank B, Bank B owes the depositor $90. Also, Bank A owes Bank B $90. Bank B sends the check to the Fed, the Fed debits Bank A reserve account $90 and credits Bank B reserve account $90 to settle thing ups. Now Bank B has excess reserves of $81. It only needs to hold $9 (=.10 * 90) in reserves. The process repeats itself and Bank B makes a loan for $90. Suppose the $90 check gets deposited at Bank C. BANK B BANK C Assets Liabilities Assets Liabilities res 9 dep 90 res 81 dep 81 loans 81 Repeat the same process again. BANK C Assets BANK D Liabilities Assets Liabilities res 8.10 dep 81 res 72.90 dep 72.90 loans 72.90 ETC. How much money (deposits) are created from the original $100 deposit? Total change in deposits = $100 + $90 + $81 + $72.90 + $65.61 + … = $1000 In this simple case we have: money multiplier = 1 / RRR = 1 / .10 = 10 Total change in deposits = money multiplier * initial deposit = 10 * 100 = 1000. This assumes no funds are taken out as cash, there are no time deposits, or MMMF. The M2 money multiplier can be derived. M2 = C + D +T + MMMF MB = C + R M2/MB = (C + D + T + MMMF) / (C + R) Divide by D and you get M2/MB = (C/D +D/D + T/D + MMMF/D) / (C/D +R/D) or M2 = (M2MM)*MB Higher C/D and R/D lowers the M2MM. Higher T/D and MMMF/D increases the M2MM. Suppose C/D = .4, R/D =.10, T/D = .05, and MMMF/D = .05 M2MM = 3 Increase R/D = .15  M2MM = 2.73 Increase C/D = .45  M2MM = 2.82 Increase MMMF/D = .10  M2MM = 3.1 Higher C/D means in each round, funds leak out of the banking system, reducing deposit expansion. A higher R/D means smaller loans are made in each round. With a higher T/D or MMMF/D, more funds stay in the banking system, which can be loaned out. Year Size of M2MM 2000 8.13 2001 8.37 2002 8.28 2003 HOW DOES THE FED CONTROL THE MONEY SUPPLY? 1. It set the required reserve ratio. Changes infrequently because of high transaction costs. 2. It can lend to bank via the DISCOUNT WINDOW. Charge interest equal to the discount rate (administratively set, follows the market, now set above the federal funds rate) 3. Open market operations – the Fed buys or sells asset (U.S. government bonds) from or to the public (usually major banks). Fed buys bonds  private bank holdings of bonds falls and reserves increase (Fed credit the bank’s reserve account), increasing (the growth) the money supply. Fed sells bonds  private bank holdings of bonds increases and reserves decrease, decreasing (slows the growth) the money supply. Today, monetary policy (control of money supply) is carried out via the federal funds market. This is a short-term (usually overnight) market where banks can borrow or lend funds from or to other banks. The Fed set a TARGET federal funds rate at the FOMC meeting. It then tries the use open market operations to control the amount of reserves in the banking system and the federal funds rate. Because the Fed does not have day to day, even week to week data on the money supply, they use the federal funds rate as an indicator of monetary policy. It has a much stronger effect on short-term rather than long-term (more likely to influence I) interest rates. Cook and Hahn find that for a 1% increase in the target (and actual) federal funds rate, other longer term rates move by 3 month rates - 55 basis points (100 basis points = 1%) 1 year rates – 50 basis points 5 year rates – 21 basis points 20 rates – 10 basis points The Fed has been lowering the target federal funds rate since the beginning of 2000. From 6% to its current value of 1% (7/03). They have been buying bonds in its open market operations in order to increase reserves in the banking system and lowering the Federal funds rate (increasing the growth in the money supply). Increasing the reserves in the banking system in the supply of reserves in the federal funds market, lowering the federal funds rate. Money Growth and Inflation in the long run What determines the value (or purchasing power) of money? The supply and demand for money determines the price level (P) and the value of money (1/P). An increase in P, other things constant, results in a reduction in purchasing power of money. If P = 2, then 1/P = ½  One dollar can buy ½ unit of the good. If P = 4, then 1/P = ¼ As the price level increases, holding income constant, the value of money falls. In order to be able to buy the same number of goods, nominal money demand increases. Money demand describes the money holding behavior of individuals. Assume economy is in long-run full-employment equilibrium. Ms = M is determined by the Fed. Md = f(1/P, y) The interest rate can be added to it. It measures the O.C. of money. It has a negative effect on money demand. Higher P -> lower 1/P -> higher Md Higher y -> higher Md This is a transaction demand for money. Higher income implies more transactions. The one-time increase in Ms causes an excess supply of money at the original price level. Since people are holding more dollars than they demand, they get rid of them by purchasing goods and services. Since the economy is at fullemployment, prices rise and you experience inflation. Now suppose technology increases full-employment output. This increases Md, the excess demand for money causes prices to fall. Expenditures are lower because people want to hold more money to buy goods and services. QUANTITY THEORY OF MONEY Classical Dichotomy suggests, that in the long-run, there is no relationship between money and real output. So, increases in money raise prices not real output. Velocity of money = V = Y / M = the rate at which money changes hands or turnover. How many times is a dollar spend purchasing goods and services during a year (average). Velocity needs to be stable or predictable for the theory to work. Year M2 velocity 2000 2.05 2001 1.93 2002 1.86 2003 Real output is determined by y = Af(L,K). EQUATION OF EXCHANGE V = Y/M Y = P *y V = P*y/M MV = Py  total expenditures = nominal GDP If V and y are constants, then an increase in M causes a proportional increases in P. Inflation is a monetary in nature. % change M + % change V = % change P + % change y % change P = % change M + % change V - % change y If V is stable, then its % change is zero (extreme case). % change P = inflation = % change M - % change y EXAMPLES: 0 = 5% - 5% 2% = 7% - 5% 1% = 7% - 6% Increases in the money supply growth rate increases inflation in the long-run. Increases in real growth decreases inflation in the long-run. See figure 4 page 359 for graphs of hyperinflations. We can use the quantity theory of money to predict inflation. i = r + expected inflation The real interest rate is determined by saving and investment. See figure 5 page 362. PROBLEMS WITH INFLATION 1. Unexpected changes cause a redistribution of purchasing power between borrowers and lenders. 2. Hurts people on fixed incomes. 3. High inflation is associated with high variability in inflation. This reduces the information content of prices. It is difficult to differentiate between relative and overall price changes. Inefficient allocation of resources. Difficult to determine r, reducing investment. The result is lower output. 4. If high enough, people spend their time trying to protect themselves for the loss of purchasing power rather than producing goods and services, output falls. These are called shoeleather and menu (costs of changing prices) costs. 5. Inflation is a tax on money holdings reducing its purchasing power. Inflation of 5% lowers a dollars buying power by 5%. Its as if the government tax ever dollar you hold by 5%. However, politicians didn’t have to vote on an unpopular tax increase. There is an incentive for governments to inflate the economy. An independent central bank helps. 6. Tax distortions. Income tax brackets are index to the CPI, but capital gains is not. Inflation causes prices of assets to rise. You pay tax on it. Should index purchase price to the CPI to eliminate this problem (1 – t)i = after tax nominal interest rate (1 – t)i – inflation = after tax real rate. Assume t = .10, i =.06, and inflation = 0 (1 - .10).06 – 0 = .9*.06 – 0 = .054 rather than .06 due to the tax. With zero inflation, the before tax i = before tax r = .06. The after tax i = after tax r = .054 Assume .03 expected (and actual inflation) i = .09 and r = .06 without taxes. With taxes (1 – t)i – inflation = .9*.09 - .03 = .081 - .03 = .051 Because the nominal rate is taxed, inflation reduces the after tax real rate. Even if the inflation is expected! This hurts savers